Speaking of the Egan-Jones Lawsuit...

Its current lawsuit is putting ratings companies in the news. But isn't there a bigger, more troubling issue with the whole system in general?

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So Egan-Jones is being sued by the SEC. The primary reason is that the company allegedly overstated its experience in rating government bonds and asset-backed securities, or ABS. It also looks like Egan-Jones twice rated companies that employees owned stock in.

I certainly disagreed with Egan-Jones on their assessment of Jefferies (JEF), and in that case, I turned out to be correct, but they are not being sued for having incorrect ratings; they are being sued because their application (done in 2008) overstated their skills. Why that wasn't checked in 2008 is a bit of a mystery to me, as well as anyone else with access to a computer... but somehow, four years later, that came up in a review? It all seems strange, but that is missing the forest for the trees. Let's look at the forest.

This refers to Egan-Jones' application to become a Nationally Recognized Statistical Rating Organization, or NRSRO. This designation is important in many ways. Once you achieve NRSRO status, some of the bond indices will use your ratings in determining which bond index a particular company's or country's debt belongs to. That alone can influence the price of corporate debt: Notice Ford's (F) bonds improved yesterday after Fitch upgraded to investment grade.

But that is only the tip of the iceberg. Many investor and regulatory capital rules are based on NRSRO's ratings. So by becoming a NRSRO, your ratings determine how much capital regulated entities hold against positions in your debt. That is important, and with many of the regulatory capital rules being "cuspy" where there is a big difference in capital charges between A- and BBB+ for example, these ratings can have a huge impact on the cost of capital of the issuers.

That seems like a big responsibility, right? Well, actually, no. In the US, so far, the ratings have been determined to be only "opinion" and are in fact protected as free speech. So let's look at the steps here.

Get the NRSRO designation from the SEC.

Rate bonds, and the bank and insurance regulators will use those ratings in capital determination.

The ratings are then used to determine how much capital regulated entities hold against a position... but although the company has an official designation from the SEC, the ratings are deemed to be "opinion" and protected as free speech.

It seems totally illogical that ratings are designated as opinion, yet to matter the rating agency needs SEC approval, and then the ratings are used by regulators. That seems bizarre, especially since the investors pay for these ratings.

Oops, the investors don't pay for ratings -- the issuers do. So the general practice is for issuers to pay for ratings. If I haven't lost you yet, let's just think about what this means. The rating that a NRSRO gives your debt has a potentially major impact on your cost of capital, yet you are the one paying for it? And if the NRSRO makes a major mistake, it cannot be sued? Right, no conflict of interest here.

No wonder Warren Buffett owns a piece of Moody's (MCO). It isn't quite a monopoly, but there is a limited number of competitors because you do need the SEC's sanction. It is crucial as many rely on the ratings because of investment guidelines and regulations. You get paid every time an issuer needs to issue, and with debt constantly rolling over, it's an annuity. On top of it all, you can't be sued in the US if you are wrong, though the CEO can be forced to resign if he does something unpopular like cut the US credit rating (as the head of the S&P found out).

Then comes the best part of this lawsuit. The only issuer who doesn't pay for ratings is... you guessed it, governments! So part of what Egan-Jones is being sued over is their application to rate government bonds, and government rating don't actually generate revenue for the company.

I continue to watch the trial in Australia about the CPDOs, a type of credit derivative, that were sold there. CPDOs were one of the most mis-rated products that were rushed to market and defied common sense, all in an effort to generate huge fees for the banks and the rating agencies. It would be encouraging to see the rating agencies lose that case and to see them face more pressure here for mistakes.

In the meantime, we live in a world where the application and following of procedures is more important than being correct, and where in spite of government involvement -- and in fact, with approval of such agencies -- their output is protected as free speech.

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